Service Intends to Disallow Theft Loss Deductions for Declining Stock Prices

The Service has advised it intends to disallow theft losses for declines in stock value due to the disclosure of accounting fraud and other misconduct by a corporations officers and directors; also, it may impose penalties under Sec. 6662.

Losses in General

Sec. 165(a) allows a deduction for any loss sustained during the tax year not compensated for by insurance or otherwise. Under Regs. Sec. 1.165-1(b), generally, the loss must be evidenced by a closed and completed transaction, fixed by an identifiable event(s) and actually sustained during the tax year.

According to Regs. Sec. 1.165-4(a), no deduction is allowed under Sec. 165(a) solely on account of a decline in stock value when the decline is due to a market fluctuation or to another similar cause. However, a deduction is allowed under Sec. 165(a) if the stock is worthless and has no recognizable value. A decline in stock value is not allowed as a deduction until the tax year in which the loss is actually sustained as a result of a sale or exchange or the stock becoming wholly worthless. Under Regs. Sec. 1.165-5(c), a loss for wholly worthless stock may be deducted under Sec. 165(a), but is subject to capital loss limits under Secs. 1211 and 1212.

Theft Losses

Individuals may deduct theft losses under Sec. 165(c)(3). Whether a loss is a theft loss is determined by examining the law of the state where the alleged theft occurred (Edwards, 232 F2d 107 (5th Cir. 1956); Viehweg, 90 TC 1248 (1988)). Thus, to claim a theft loss, a taxpayer must prove that the loss resulted from a taking of property that is illegal under the law of the state where it occurred and that the taking was done with criminal intent (Rev. Rul. 72-112).

In cases involving stock purchased on the open market, the courts have consistently disallowed theft loss deductions for a decline in stock value due to corporate officers misrepresenting the corporations financial condition, even when the officers were indicted for securities fraud or other criminal violations. In Paine, 63 TC 736 (1975), affd w/o pub. op., 523 F2d 1053 (5th Cir. 1975), the taxpayers claimed a theft loss deduction for a decline in stock value stemming from a corporate officials misrepresentations of the corporations financial status. The court noted that the taxpayers did not purchase the stock from the corporate officers who made the misrepresentations, but on the open market. In MTS International Inc., 169 F3d 1018 (6th Cir. 1999), an individual taxpayer sold at a loss stock that was acquired on a public stock exchange and argued that the substantial decline in value was due to criminal conduct by the corporations officers. The Sixth Circuit concluded that the loss was not a theft loss.

Accordingly, the Service will disallow a theft loss deduction under Sec. 165(a) for a decline in the value of stock that was acquired on the open market for investment. If the stock is sold or exchanged or becomes wholly worthless, any resulting loss is a capital loss.

Notice 2004-27, IRB 2004-27, 16